"I Expect A Financial Accident To Occur": Gavekal Reveals A New, "Flashing Red" Warning

Much ink has been spilled by analysts sounding the alarm over the rapid flattening in the US Treasury yield curve observed over the past year, as many have rushed to remind markets of the conventional wisdom that an inverted curve is one of the most reliable indicator of an imminent recession.

At the same time, others have spoken out against this orthodoxy, pointing out that there can be as much as a 1-2 year lag between the moment of first inversion and when the economic contraction officially arrives.

Yet others, note that due to the Fed's direct influence on the long end (where the market tends to frontrun central bank monetization of Treasuries), the yield curve - which represents the market rate of interest on the short end, and the natural rate of interest, or "r star" on the long-end - has lost all signalling value.

Now, in a hybrid take on the yield curve concept, GaveKal's Charles Gave says that the yield curve is certainly informative... just not that of the public sector, but the private sector instead.

According to Gave, recession timers should ignore government debt and focus instead on the corporate credit market. Here, the U.S. natural rate of interest can be represented by yields on longer-dated industrial bond rated Baa by Moody’s, while the market rate is captured by the prime lending rate charged by U.S. banks.

The problem is that if Gave's interpretation is right, the US economy is about to fall off a cliff.

"The private sector yield curve reading stands at zero, or right on the threshold where trouble can be expected to begin" Gave wrote today in a note to clients, quoted by Bloomberg. "Should this spread move into negative territory, I would expect a financial accident to occur outside of the U.S., a U.S. recession, or possibly both."

Translation: even the smallest deviation from the current unstable equilibrium could unlock a recession.

Looking at the chart above, Gave warns that either a U.S. recession has taken place within a year of the private sector yield curve inverting, or a “financial accident” has occurred in other economies with currencies linked to the dollar, which would be all of them.

Why does Gave pick this particular spread? Because as he explains, artificially depressed prime rates below the natural rate of corporate credit have allowed banks to generate “artificial” money, kept “zombie” companies alive, but most of all permitted most viable corporations to engage in “financial engineering” such as issuing debt to repurchase stocks, all of which are predicated on cheap borrowing costs continuing indefinitely; the risk of course, is that the credit-funded party ends once the curve inverts, Gave said.

Based on this measure, “we are entering dangerous territory,” he concluded. If the private sector curve inverts, then zombie companies - the same ones we highlighted back in March as surviving only thanks to central bank generosity - "which will fail and capital spending will be cut, as firms move to service debt and repay principal. Workers will get laid off and the economy will move into recession."

In summary: to Gave the curve is not only informative, but is indeed flashing a "red warning", one which suggest a "financial accident is about to occur", only it's not the government curve, but the corporate curve where this particular Cassandra can be found.